Individual Retirement Accounts: Traditional or Roth?

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From 401(k) to HSAs, there seems to be no shortage of ways to help people save for retirement. The most versatile vehicle for this purpose is the individual retirement account. Investments held in an IRA grow tax-free, which means dividends, interest, and capital gains won’t cost you as long as the money stays in the account. Since IRAs are retirement accounts, withdrawals made before age 59 1/2 results in a 10% early distribution tax unless it qualifies for an exemption. For example, you may pull up to $10,000 for the purchase of a home if you are a first-time homebuyer. This applies to both traditional and Roth IRAs.

A traditional IRA is a tax-deferred account, which means contributions are deducted from income in the year you deposit. Funds are subject to income tax only when you withdraw. There are several restrictions with this type of account, however. After the age of 70 ½, you are no longer able to put money in and must actively withdraw the required minimum distribution based on the previous year’s account balance and your age. If you qualify for an employer-sponsored retirement plan such as a 401(k), that may affect how much of your IRA contribution is tax-deductible. For 2019, your adjusted gross income must not exceed $74,000 as an individual, or $123,000 for a married couple filing jointly. This applies as long as you qualify for an employer-sponsored account, even if you haven’t opened one.

The non-traditional, Roth IRA comes with its own unique set of options. With a Roth, your tax break comes later. Deposits into the account do not reduce your income in the year you contribute. However, if the account remains open for more than five years and you are at least 59 ½, anything you take out will be tax-free. Unlike a traditional IRA, you can contribute to a Roth indefinitely. There is no forced distribution, which means your investments can continue to grow tax-sheltered. While withdrawal of investment earnings (such as dividends or capital gains) before age 59 ½ are subject to the 10% early withdrawal tax, you can take out any contributions made to the account with no consequences.

Roth IRAs come with their own set of restrictions. Your ability to contribute to a Roth IRA depends on your adjusted gross income. If your annual income exceeds $135,000 by yourself or $199,000 with a spouse, you will not be able to open or contribute to a Roth IRA. Before you dismiss that option however, there is a loophole. You can always contribute to a traditional IRA, then convert it as a backdoor Roth.

For either type of IRA, you must contribute from earned income either from a job, business or farm. You may not use unemployment benefits, child support, alimony, or income from investments. If your spouse does not have earned income, the working partner is able to contribute to a spousal IRA as long as you file taxes jointly. Contribution limits are also per person. You are welcome to have as many retirement accounts as you want, but the total contribution must fall within your individual limit.

There is no one-size-fits-all answer to choosing one type of IRA over the other. If you are in a higher tax bracket now than you expect to be in when you retire, a traditional IRA can result in significant tax savings. People just starting out in their careers may belong to a lower tax bracket they don’t expect to stay in. In that case, paying taxes now in order to make tax-free withdrawals later is advantageous. Yet, how many people can say with certainty what tax bracket they will be in 20, 30, or 50 years from now?

If you are unsure, consider splitting your annual contribution between both types of accounts. A mix of tax-deferred and tax-free assets will give you more options for managing your income in retirement than if you bet on one type of account and get it wrong. If your income varies, you can also contribute more to the traditional IRA in years that you make less money in order to take advantage of the lower tax bracket.

While tax savings will be the deciding factor for most people, there are additional benefits to each that may better fit your needs. If you’re approaching retirement, you may prefer a Roth, which does not require you to make minimum distributions after age 70 ½. On the other hand, contributing to a traditional IRA will lower your annual income in the present, potentially enabling you to take advantage of other tax breaks such deducting student loan interest.

Opening an IRA is easy. Unlike employer-sponsored accounts such as a 401(k), anybody who has earned income is eligible to open an IRA at a variety of financial institutions including banks, brokerages, and mutual fund providers.

Whether you choose a traditional or Roth IRA, making the maximum contribution whenever possible will allow you to take advantage of tax savings that can go back into growing your retirement account. If you are unsure which IRA is right for you, consult a financial advisor who can help you put together a comprehensive plan for your situation.